Understanding The Interest Rate Game

Interest rate announcements from the Reserve Bank of Australia have almost become a monthly obsession for many, however a recent change by one major bank could lead to a major shift.

Prior to the global financial crisis which kicked off in 2007, almost all Australian banks and financial institutions adjusted their standard variable mortgage rates in line with the monthly changes announced by the Reserve Bank (RBA).

Australians had come to expect that a 0.25% reduction by the RBA would lead to a 0.25% reduction in their own mortgage rate, however during the financial crisis the banks started to make changes outside of the RBA movements. This sometimes means not passing on full rate reductions, and in other cases passing on more than the rate increase.

Because of the way the banks have historically matched the RBA rate movements, most Australians believed that it was the RBA rate which had the biggest impact on mortgage rates. Comments by the government and media only reinforced this view, and surprisingly the banks did little to argue against it.

Why shouldn’t the banks match the RBA?

Australian banks lend billions of dollars to Australian home owners every year. They don’t hold sufficient deposits in savings accounts from clients to cover these loans, nor do they obtain sufficient funding from the RBA. Instead, they obtain funds from the global wholesale money markets, in particular from Europe and the USA.

For some banks and other financial institutions it has been reported that up to 40% of their mortgage funding comes from overseas money markets. In the case of the non-bank lenders, it is considerably higher.

The money markets of Europe and the USA are not affected by interest rate changes by the RBA, so when the RBA cuts rates by 0.25% it does not mean that the banks are suddenly obtaining their entire mortgage funding at 0.25% less.

So why are the banks increasing their rates, or not passing on the full rate reductions?

Europe and the USA are both experiencing particularly turbulent times in their respective economies. In the case of Europe, they are currently going through potentially the most dangerous financial crisis in their recent history.

Because of the economic risks in Europe, many of the largest money markets in the world are either refusing to lend out money or are demanding significantly higher returns to represent the perceived higher risks.

As Australian banks obtain a substantial percentage of their funds from overseas markets, any increase in the cost of money overseas translates directly into higher borrowing costs for the bank. This portion of the banks’ funding essentially has nothing to do with the RBA interest rate.

Changing the game

So if the RBA rate doesn’t have such a huge impact on the mortgage rates that the banks must charge to remain profitable, why do the banks insist on changing their rates largely in response to RBA changes?

This was the question asked by many, and following the December RBA rates decision the ANZ bank announced that they were going it alone with their monthly mortgage rate reviews. Instead of following the Reserve Bank interest rate cycle, the ANZ has announced that it will conduct its own review of its funding costs and will announce any changes to its rates on the second Friday of every month.

This means that the ANZ could change their rates by any amount they wish, irrespective of any changes made by the RBA.

Although some consumers may see this as a negative move, the nature of competition and the fact that exit fees have recently been outlawed on new mortgages should mean that ANZ’s mortgage rates will not move drastically out of step with the rest of the banks.

Whether or not ANZ’s move is a good thing for consumers remains to be seen, but it is certainly a major departure from the standard practice, and it will be interesting to see if any of the other major banks follow suit.

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